Puerto Rico’s black swans

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Puerto Rico is a small island with a population of 3.7 million people and a municipal debt load of $104 billion. Only Florida, Illinois, New Jersey, New York, Ohio, Pennsylvania and Texas – states that are all substantially larger – have more debt outstanding. Puerto Rico’s government has been financing its deficits with bond issuance, although it recently vowed to put an end to this practice in 2014. The island’s economy has been contracting for several years, but recently it began to move slowly toward positive growth. Puerto Rico’s labor market is similarly weak, with an unemployment rate of 15 percent, nearly double the national rate of 8.1 percent.

In short, Puerto Rico’s debt-to-GDP load and unemployment rate are greater than those of any state in the country. It’s on a knife’s edge, and it’s easy to imagine several black swans that could precipitate real fiscal distress.

Puerto Rico’s bonds enjoy some special qualities that keep demand for it at high levels. The island’s municipal debt enjoys a triple-tax-free exemption across the country, meaning that investors in any state do not have to pay federal, state or local taxes on it. Wealthy bondholders in high-income tax states like New York and California can earn more yield by purchasing tax-exempt Puerto Rican debt than they could if they purchased the bonds of other states. Moreover, many municipal-bond single-state mutual funds are able to take advantage of this tax-exempt status and invest in Puerto Rico’s bonds. For instance, a mutual fund that is nominally invested only in California bonds is allowed to own Puerto Rico bonds as well, but not bonds from Texas or New York.

Despite being widely held, Puerto Rico’s bonds rank near the bottom of the investment grade scale, and there are a lot of opinions about how risky they are. A new bond investing website, Learn Bonds, recently interviewed two big mutual fund managers with opposing views on the island’s debt. Marc Prosser from Learn Bonds first interviewed BlackRock’s Peter Hayes:

Peter thought the credit risk on many PR bonds outweighed the benefits of extra yield. One of the concerns he has with Puerto Rico is that the economy is not diversified and focused heavily on tourism.

Prosser then interviewed Rochester Funds’ Scott Cottier, who oversees that firm’s municipal-bond mutual fund division. Cottier believes that Puerto Rico’s debt is a good investment because its government is reducing spending and increasing revenues; because pension liabilities have flatlined; and, most important, because the federal government would step in to backstop its debt if it were to default.

In a March commentary, Breckinridge Capital Advisors, an institutional and private-client fixed-income portfolio management firm, identified a number of trigger events that could possibly cause Puerto Rico to default:

Breckinridge did not include an economic slowdown on its list, but I think with Puerto Rico’s high level of leverage it should be included. Breckinridge sums it up:

Although the threat is not imminent and the risk remains slim, Breckinridge believes the possibility of a default by Puerto Rico is sufficient to warrant the attention of municipal investors.

A Puerto Rico default would have negative market implications. High grade investors should understand the Commonwealth’s fiscal problems because a default might trigger mutual fund redemptions and bouts of illiquidity.

However, Puerto Rico’s debt situation is unique and unparalleled in the United States. A debt crisis in Puerto Rico will have limited impact – if any – on the extremely remote likelihood of a U.S. state default.

If Puerto Rico’s economy picks up, its government can patch the holes in its budget. But if the U.S. economy slides into recession again, Puerto Rico will be hit especially hard. The question bondholders are asking is whether they are getting adequately paid for the risk that a black swan event might occur.

Well, if you take into account 9 million Americans have are no longer being counted since 2008 in the employment report- that’s over 11% of the entire work force which simply vanished into thin air in aprox. 4 years.

There is no way they can double that more accurate (by the real definition of unemployment) with the 8.1 that is actually in the island. -I mean can this ‘indolent’ people get to a 22%?

I think this will best describe what is really going on…

Excerpt from book: “_*The History of Puerto Rico* From The Spanish Discovery To The American Occupation_” by R.A. Van Middeldyk (1915)

“[Nothing]…have been sufficient to _make these islanders abandon the indolence_ with which they regard the most important of all arts, and the first obligation imposed by God on man-namely, the cultivation of the soil.”

I believe this picture will clearly describe or better yet should be the illustration of that parragraph.

I want to correct a few misconception by some of the “experts” quoted in this article.

First, when Mr. Peter Hayes says that the Puerto Rican economy relies heavily on tourism, he neglected to mention that tourism barely represents 6% of the Commonwealth’s GDP. The largest sector of the Island’s economy by far is manufacturing.

Regarding Mr. Cottier’s assertion that the U.S. federal government would bail out Puerto Rico, I highly doubt that it would, since it refused to bail out California, which is the 8th or 9th largest economy in the world.

In terms of the possibility of tax exemption being taken away, that is highly unlikely since this would require either a change in the country’s political status as a Commonwealth, or an explicit act of the U.S. Congress that would have far reaching economic implications in the U.S. as well as in Puerto Rico. Very slim possibilities that U.S. pharmaceuticals, the 4 million Puerto Ricans in the U.S., as well as other influential investors, and politicians would let that happen. Puerto Rico would also not likely want to shoot itself in the foot and eliminate its local tax exemptions.

What Puerto Rico needs is to stop financing its debt with more bond issuance and increase labor force participation through a restructuring of U.S. welfare transfers. In the short run, an additional U.S. tax incentive would produce needed growth. More economic autonomy provided by enhancing Commonwealth status or eventual independence would unleash Puerto Rico’s economic potential in the long run.

Author Profile

I’m Cate Long and I write about the retail fixed income markets including municipal bonds. My primary interest is creating tools and systems to help retail investors understand bond markets. I’ve worked for a number of years with industry standards organizations, regulators and Congress to help craft a more transparent and fair framework for investors to participate in the fixed income markets. I'm a guest contributor to Reuters.com. Any opinions expressed are mine alone.